Credit markets swallowed a mouthful recently, when Fitch and S&P Global Ratings downgraded Kraft Heinz from BBB- to a junk-level BB+, moving its $29 billion in debt into the high yield space. The company is the bond market’s largest “fallen angel” in nearly 15 years and is the third largest issuer of high yield debt. Some investors with limits on their high yield exposure were forced to sell, which dropped the price of Kraft Heinz’s 30-year bonds by about 14 points over two days. Prices have since improved, rebounding approximately five points as high yield investors have moved in to buy positions.
Some folks are taking a broadly pessimistic view on credit markets with this latest development, suggesting that it may indicate a sour turn for the supersized BBB market, the lowest tier of the investment-grade segment. BBBs now account for about half of that universe, or $2.9 trillion in assets, and are seen as vulnerable as the economic cycle matures.
Indeed, Kraft Heinz is in some ways a poster child for vulnerable traditional issuers. The product of a 2015 merger orchestrated by Berkshire Hathaway and 3G Capital (both retain ownership stakes), the company took on a lot of debt, but continued to struggle to sell its familiar processed foods amid consumers’ general migration to healthier products. It took a $15 billion charge on its brands last year.
However, just as snack foods aren’t for everyone, we don’t think that Kraft Heinz is indicative of BBB credits at large. In this case, management made a conscious decision to maintain its high dividend in the face of elevated debt—knowing, based on rating agencies’ past statements, that a downgrade would probably result. In doing so, it reversed previous commitments to maintaining investment grade ratings made throughout 2019. Managements certainly have the right to change strategy, and in this case taking the company’s ratings to junk status was a conscious management decision; only time will tell whether it was a good one or not.
So far, the market reaction is edifying. Although the downgrades were announced on Friday, February 14, the company’s bonds had actually sold off sharply on its earnings call the day before, when the company reinforced its commitment to maintaining its dividend and not aggressively pursuing asset sales—a change in direction and a sharp contrast with previous statements made last year. Equity investors found no short-term comfort in this change of strategy as the stock sold off roughly 10% in tandem with the bonds.
Not all companies have gone this route. Anheuser-Busch InBev chose to trim its dividend in 2018 to focus on improving cash flows, reduce leverage and support its credit rating. Macy’s, another recent downgrade, might have preferred to keep its higher rating, but is facing a truly challenging environment in bricks-and-mortar retail. Other rating cuts have also been largely due to company- or sector-specific issues.
Looking at the BBB universe at large, we see improvement, not deterioration. Despite widespread concern over a potential increase in fallen angels, the stable economy and earnings backdrop, supported by central banks, have limited rating downgrades. Moreover, the leverage of BBB issuers has declined in recent quarters from peak levels, driven by both absolute debt reduction and improvements in EBITDA, while free-cash-flow generation has also improved. (Read our new update of our previous Insights on BBB market conditions and navigating the BBB sector.)
Yes, the BBB segment is probably too large and some issuers face pressures, but we believe that the overall picture appears to be stable and improving. As for high yield investors, this is a lot of volume to digest all at once. That being said, the process is well underway; the company’s 30-year bonds are now up five points from their lows and finding their way into new high yield portfolios.
And while the recent price action in Kraft Heinz is dramatic, it’s more instructive to look at what’s happened over the past six months. The 30-year bond it issued most recently carries a coupon of 4 7/8% and was priced in September at 98.57, a modest discount to par and a spread of 275 basis points over Treasuries. Based upon management’s assertion that there was “board-level” commitment to maintaining an investment grade rating, generally favorable credit market conditions and declining interest rates, the bonds had moved up in price to approximately 110 and in spread to plus-225 in the days before the company’s recent announcement. As I write this, they now trade at a price of 101.43 and a spread of 285—in other words, very close to where they were issued as an investment grade credit last fall.
All in all, one can conclude that the market has handled this surprise pretty well. Some might argue that investors are complacent, but regardless of your forward view, the reaction points to credit markets today that are quite healthy. This isn’t to say that they are danger-free. Spreads are tight, and the economy is highly dependent on monetary support in the face of the coronavirus and other growth suppressants. Skepticism and a careful diet may be prudent, even as investors look to enjoy rewarding meals when they reach the market table.
In Case You Missed It
- Japan 4Q 2019 GDP (Preliminary): -6.3% annualized rate
- NAHB Housing Market Index: -1 to 74 in February
- U.S. Producer Price Index: +0.3% in January month-over-month and +2.1% year-over-year
- U.S. Housing Starts: -3.6% to SAAR of 1.57 million units in January
- U.S. Building Permits: +9.2% to SAAR of 1.55 million units in January
- Japan Consumer Price Index: +0.7% in January year-over-year
- Japan Purchasing Managers’ Index: -1.2 to 47.6 in February
- Euro Zone Purchasing Managers’ Index: +1.2 to 49.1 in February
- U.S. Existing Home Sales: -1.3% to SAAR of 5.46 million units in January
What to Watch For
- Tuesday, February 25:
- S&P/Case-Shiller Home Price Index
- U.S. Consumer Confidence
- Wednesday, February 26:
- U.S. New Home Sales
- Thursday, February 27:
- U.S. Durable Goods Orders
- U.S. 4Q 2019 GDP (Second Preliminary)
- Friday, February 28:
- U.S. Personal Income and Outlays
- Chinese Purchasing Managers’ Index
Statistics on the Current State of the Market – as of February 21, 2020
|S&P 500 Index||-1.2%||3.6%||3.6%|
|Russell 1000 Index||-1.1%||3.8%||3.9%|
|Russell 1000 Growth Index||-1.5%||4.6%||6.9%|
|Russell 1000 Value Index||-0.7%||2.9%||0.7%|
|Russell 2000 Index||-0.5%||4.1%||0.7%|
|MSCI World Index||-1.1%||2.7%||2.1%|
|MSCI EAFE Index||-1.2%||0.6%||-1.5%|
|MSCI Emerging Markets Index||-2.0%||2.1%||-2.6%|
|STOXX Europe 600||-0.5%||2.2%||-0.3%|
|FTSE 100 Index||0.1%||2.0%||-1.4%|
|CSI 300 Index||4.1%||3.6%||1.3%|
|Fixed Income & Currency|
|Citigroup 2-Year Treasury Index||0.2%||0.0%||0.6%|
|Citigroup 10-Year Treasury Index||1.1%||0.5%||4.2%|
|Bloomberg Barclays Municipal Bond Index||0.6%||0.5%||2.3%|
|Bloomberg Barclays US Aggregate Bond Index||0.6%||0.5%||2.5%|
|Bloomberg Barclays Global Aggregate Index||0.1%||-0.7%||0.6%|
|S&P/LSTA U.S. Leveraged Loan 100 Index||0.1%||0.1%||0.3%|
|ICE BofAML U.S. High Yield Index||0.1%||1.2%||1.2%|
|ICE BofAML Global High Yield Index||0.1%||0.8%||0.9%|
|JP Morgan EMBI Global Diversified Index||0.5%||1.2%||2.7%|
|JP Morgan GBI-EM Global Diversified Index||-0.7%||-0.2%||-1.5%|
|U.S. Dollar per British Pounds||-0.4%||-1.7%||-2.2%|
|U.S. Dollar per Euro||0.1%||-2.1%||-3.3%|
|U.S. Dollar per Japanese Yen||-1.7%||-3.0%||-2.7%|
|Real & Alternative Assets|
|Alerian MLP Index||-2.4%||-2.2%||-7.7%|
|FTSE EPRA/NAREIT North America Index||0.3%||4.9%||6.3%|
|FTSE EPRA/NAREIT Global Index||-0.7%||3.1%||2.7%|
|Bloomberg Commodity Index||1.2%||2.0%||-5.5%|
|Gold (NYM $/ozt) Continuous Future||3.9%||3.8%||8.3%|
|Crude Oil WTI (NYM $/bbl) Continuous Future||2.6%||3.5%||-12.6%|
Source: FactSet, Neuberger Berman.